Interest collected but not earned;

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Bulletin HASKINS & SELLS 37
Interest Collected But Not Earned
A VERY interesting question grows out of
that which is the subject of pamphlets
issued recently by a number of national
banks. The Comptroller of the Currency
in his call for a statement of condition, as
of November 1, 1918, reminded national
banks that beginning January 1, 1919, pro­vision
would have to be made for interest
earned but not collected, as well as interest
collected but not earned.
In a previous call there appeared the fol­lowing
notice: "As it has been the custom
of many national banks to credit discounts
as collected directly to profits and to credit
profits with accruing interest only after act­ual
collection, it has been thought proper
to give the banks a reasonable time to make
the adjustments which will be required in
order to report accurately items 21 (inter­est
earned but not collected) and 27 (in­terest
and discount collected or credited in
advance of maturity and not earned)."
The treatment of the first item is simple
and follows what accountants have been ad­vocating
for years in spite of the conten­tion
made by some banks that the procedure
is unnecessary because one period will off­set
the other.
The second item raises the question, ac­ademic
perhaps, as to whether a bank in
discounting a note for a customer really
collects the interest or discount in advance.
The practice of banks, as is generally
known, is to compute the interest on the
principal at the rate agreed and for the
time involved, and deduct the interest from
the amount for which the customer has ap­plied,
actually loaning him the net amount.
Take, for example, a case where the loan
requested is $1,000.00; the rate 6%; the
time three months. By a process of book­keeping,
the transaction is made to appear
as if the bank had loaned $1,000.00 and
collected in advance the interest in the
amount of $15.00. In other words—
"Loans and Discounts" is debited in the
amount of $1,000.00; "Unearned Dis­count"
is credited with $15.00.
The same effect upon the assets of the
bank would be shown if "Loans and Dis­counts"
had been charged and "Cash"
credited in the amount of $985.00.
The matter is treated as first mentioned
because a note of this character may circu­late
somewhat and shows on its face the
amount which it will bring at maturity. If,
however, it changes hands during its life
the unearned discount must be adjusted.
It would seem therefore, offhand, that
the same result might be accomplished by
making the note for $985.00 and having it
bear interest at 6%. It would then be a
matter of adjusting the accrued interest at
the time of the transfer instead of adjust­ing
the unearned discount.
Careful consideration discloses the fal­lacy
of this argument as long as the dis­count
is calculated as at present. The pro­ceeds
of a note for $1,000.00 at 6% for
three months with discount calculated by
what is known as true discount would
amount to $985.22. This sum at 6% for
three months would amount at maturity to
$1,000.00. The proceeds of the same note
with the discount calculated by what is
known as bank discount would amount to
$985.00. This amount at 6% for three
months would amount to $999.78. While
the difference involved is for practical pur­poses
too small to have any real effect
upon the situation, it shows the principle
involved. It also brings out clearly the fact
that the second mentioned method of com­puting
the discount is more advantageous
to the lender. This perhaps explains why
the bookkeeping entries are made to show
the transaction broad instead of net.
Regardless of the method used in com­puting
the discount or the bookkeeping en­tries
which are made to record the trans­action,
the fact remains that the bank mak­ing
the loan parts with a certain amount of